Richard Clarida’s retrospective on the financial crisis

I earlier discussed several of the presentations at the monetary policy conference at the Federal Reserve Bank of Boston last week. But missed in the popular coverage of the conference was an insightful discussion by Columbia Professor Richard Clarida that expressed very nicely the conclusions that I have come to as well on the events that led us into these problems.

Clarida wrote:

The subtitle of this paper is not ‘I Told You So’ and for a good reason. I didn’t, and it wasn’t because I was shy. Rather, as will be discussed later, I, like the vast majority of economists and policymakers, suffered– in retrospect– from Warren Buffet’s ‘lifeguard at the beach’ problem: “you don’t know who is swimming naked until the tide goes out”….

The efficient markets paradigm was seen as a working approximation to the functioning of real world equity and especially credit markets. The growing role of securitization in credit markets, especially in the US, was seen as a stabilizing innovation that reduced systemic risk by distributing and dispersing credit risk away from bank balance sheets and toward a global pool of sophisticated investors. While asset prices might well drift away from fundamental value and for long periods of time, ‘bubbles’ were difficult enough to identify ex ante so that the role for monetary policy was to limit collateral damage to inflation and economic activity when they burst….

It is startling to note in the US the chasm that emerged during the ‘great moderation’ between credit extended to the household and non-financial business sectors– much of it through the ‘shadow banking’ system to be discussed below– as compared against nominal GDP. This was the ‘great leveraging’ that accompanied the ‘great moderation’….



Source: Clarida (2010; presentation slides)
clarida_debt1_oct_10.gif






Shadow bank liabilities versus traditional bank liabilities, in trillions of dollars. Source: Clarida (2010)
clarida_debt2_oct_10.gif



Clarida continued:

…greater and greater use of leverage which in turn supports asset prices which in turn support more leverage. And importantly, this channel is missing in the justly celebrated and influential Bernanke-Gertler model (1999) presented at Jackson Hole in 1999. In that model, the bubble affects real activity in two ways. First, there is a wealth effect on consumption, although that effect is presumed to be rather modest. Second, because the quality [of] firms’ balance sheets depends on the market values of their assets rather than the fundamental values, a bubble in asset prices affects firms’ financial positions and, thus, the premium for external finance. Although bubbles in valuations affect balance sheets and, thus, the cost of capital, B and G assume that—conditional on the cost of capital—firms make investments based on fundamental considerations, such as net present value, rather than on valuations of capital including the bubble. This assumption rules out the arbitrage of building new capital and selling it at the market price cum bubble– the Ponzi finance stage of a bubble in the Minsky nomenclature…. “This time it was supposed to be different” because securitization and the expertise of the ratings agencies in assessing default risk correlations across various tranches of structured products was in theory supposed to make the financial system more stable and reduce systemic risk….

With the benefit of hindsight … it seems clear– at least to this author– that the financial crisis and the credit and securitization bubble that preceded it resulted not only from spectacular failures in securities markets– to allocate capital and price default risk– but serious failures also as well by policymakers to adequately understand, regulate, and supervise these markets. Policymakers, academics, and market participants simply didn’t know what they didn’t know. They assumed that either it couldn’t happen (after all, AAA securities ‘never’ default), or if it did, it would be systemically unimportant. Until the tide went out. But by then it was too late.

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30 thoughts on “Richard Clarida’s retrospective on the financial crisis

  1. Jackrabbit

    Policymakers, academics, and market participants simply didn’t know what they didn’t know.
    And yet there WERE people that saw the bubble clearly. Some, like Magnetar and Paulson (and Goldman?) even made (a lot of) money on it. So “Hoocoodanode” doesn’t cut it.
    Why weren’t policymakers, academics, and market participants more skeptical? With so much at stake, why didn’t they investigate the warnings? Why was the madness allowed to continue to the point where the global financial system was on the brink of a collapse?

  2. PHodges

    I don’t think the Buffet metaphor goes nearly far enough. If this explanation is true, then you have to add that the lifeguards believed it was impossible for any of the swimmers to be naked despite having seen nude swimmers in the past when the tide went out and, at least in part, because they had been paid by the Society of Nudist Swimmers to testify that all of the swimmers were clothed.
    We are still excusing all sorts of “experts” for being really bad at their jobs when it matters the most to the economy. And because they have suffered little consequence, I see no improvement in their methodology or ability to examine their own past actions for systemic flaws.

  3. H.Z.

    Yet the rise of leverage and the rise of the power of the Fed are interrelated. And they are enabled by the rise of the asset managers. The deflationary cycle that Keynes described much more aptly applies to capitalists who manage their own capitals than to asset managers who manage other people’s money. The asset managers, esp those who use leverage, are much more responsive to the Fed’s monetary policy because they don’t need to worry about tail risk. They asymmetric risk/reward profile makes them the most useful enforcers for the Fed.

  4. rayllove

    I agree with the first 2 comments. The economics field is in a tragic state and the efforts to rectify the faults in a responsible manner are coming up well short.
    As for the theory in the post, it fails to include the same failure that was so obvious to begin with. That being the cost of housing being out of pace with incomes. I know a person who dropped out of high-school and yet he put his home on the market in 2006 because he foresaw the inevitable collapse (he sold it too, and probably to someone who listened to an economist).
    Clarida’s theory reminds me of the ‘run on the bank’ explanation for the Great Depression. Assuming that the ‘run on the bank’ theory excludes that the poverty rate before the crash had soared to 71% (BLS).
    It is this penchant for ignoring exploitation and inequitable wealth distribution correlations while also managing to serve their own ambitions that has made economists less and less credible. At the very least why not explain that the volume of liquidity in the economy was excessive in relation to stagnant incomes/wages. Perhaps explain that had wages risen at a faster pace that investors may not of had too much liquidity. But then of course that would lead to the problem of wages being less competitive globally. And that consideration in turn leads to the question of why only those from the poor half of the workforce must be competitive, it would I suppose be difficult to pen a theory that ignores the rather salient fact that the cost of compensation for those on the wealthy end of the workforce have bearing on global competition factors too. So that would tend to force a theorist to explain that the US is trying to claim as much global market-share as possible and so investors must have ample capital. One could even go so far as to tie in the Chinese lending us money to meet our public costs so that tax breaks would allow for more capital formation to provide even further advantages in the quest for global market-share. But then that brings it all back to the 71% poverty in 1929 again because… what the current ‘currency war’, and the GIIPS issues, and etc., is making clear, is that the underlying problem has been a lack of global AD all along, a problem which ‘was’ obscured by artificial gains. But, if a theorist were to explain that, it would also be necessary to re-explain The Great Depression. And it took economists many decades to craft the theory that shone the least accusatory light on themselves, and most importantly, on their masters.

  5. don

    I’m not a fan of Richard. IMHO, he did some rather blatantly stupid stuff, published in some rather prestigious economics journals. What’s worse, from his statments above, he may actually have believed some of it. I agree with Jackrabbit, although my own timing was off, I cannot believe any intelligent being could examine price to rent ratios up to 2005 and conclude there was no bubble brewing.
    And a good story as to why the NET domestic leverage grew seems lacking. I think the foreign savings glut, and in particular Asian currency interventions, were a key component. Finally, why only a post-war period in the first graph?

  6. Johannes

    “..dispersing credit risk away from bank balance sheets and toward a global pool of sophisticated investors”. Sounds funny. Remember Greenspan ?
    “..Policymakers, academics, and market participants simply didn’t know what they didn’t know.” – No, no, this crisis was engineered.
    Already in 2007 we went short rel.subprime hedgefonds. Order right from the top.
    “Hoocoodanode”? Of course, the bubble was well known.

  7. MarkS

    My opinion is that the defining logic error of fiscal and financial administration in America is that “We have to grow the economy out of…” the chronic fiscal deficits and unemployment that have plagued us for forty years. Regulators and administrators continually found that securitization (laying off the real cost of today’s “growth” onto the future) paid handsome dividends to both deal-makers and politicians, while providing the fuel for growth.
    I would expect that institutions created to administrate banking and commerce would have deep historical knowledge of the dangers of excessive credit expansion, and should long ago have instituted strict rules to prevent it. That those rules were ignored, diluted or abrogated since the 1980′s speaks to the perfidy and unprofessional behavior of FED governors, treasury officials, and academic economists that supported over-leveraged consumption.

  8. Qc

    All money originates from debt. Total debt outstanding (private+government) is precisely the amount of money in circulation. For those of you who think that we can grow the economy while reducing both private debt and government debt at the same time, I regret to tell you that this has never occurred based on the Fed’s flow of funds data. In order to grow the US economy, we need to grow the total amount of debt outstanding.
    Total debt outstanding can broadly be categorised as “government” or “private”. The problem is that the private debt got way too big relative to the risk-free government debt oustanding. US Government debt is equity for the private economy. So the problem is that the private economy got way too leverage relative to its equity position. Too bad economists are just beginning to discover Minsky. (there are exceptions… see http://www.youtube.com/watch?v=gRE-IDYfi8Y )

  9. ppcm

    Performing the autopsy of this ongoing crisis,is the tale of two worlds.
    The academics “If it works in theory,how or why should I check how it works in reality?”
    The financial world (all crisis start with the financial world) “If we can make it work in reality,let us put up some theories”
    In between there are multi layers of supervising bodies accomplices or ignorant of the obvious. The list is long, and since the guillotine has been abolished, let us review just very of few of them:
    Was An Equilibrium Model of “Global Imbalances” and Low Interest Rates, the stepping stone of the Philosopher’s Stone?
    Were the imbalances of the economies so difficult to trace (consumer credit/GDP,total credit loans/GDP….)?
    The outperforming profits of the banking industries, when compared to their peers in the other sectors of the economy, did not draw any attention?
    The outperformance of the banking industry when compared to the world GDP growth (out of line with past record) were not a subject of academic interest?
    The breakdown of the financial profits between trading of derivatives, loans and credit no surprise to the analysts?
    The banks leverages on real estates when compared to their capital not a subject of central banks performances and duties?
    The mere facts that private incomes were steady when private revenues on capital gains were rocketing not intriguing?
    The increase in money supply worldwide above GDP growth not drawing eyes browses?
    The obesity of the banks contingent liabilities not a subject of interest to entomologists?
    Few bright people called the tops
    The top of the consumers loans and credit at 390% of GDP in 2007 compared to 290% in 1927
    The subprime crisis.
    The list is much longer,than one day without bread and let us save it for the day without muse.

  10. RB

    I concur with so many above. Each time an academic economist or policy maker comes out and says that nobody could have known it, they diminish the profession or confirm what Bill Clinton said 9/21 – “Do you know how many political and economic decisions are made in this world by people who don’t know what in the living daylights they are talking about?”. With far less knowledge of the markets than I have even today, I was able to make two right calls – on real estate and the stock markets, although I was a year early on the stock market. Anybody who had one foot on the ground looking at the extent of the distortion in the affordability issue this coming a mile away.

  11. ppcm

    Please instead of “The top of the consumers loans and credit at 390% of GDP in 2007 compared to 290% in 1927″
    Please read: The top of the consumers loans and credit at 390% of GDP in 2007 compared to 260% in 1939.
    Those figures, are subject of arguments as regards the computation of the debts themselves when the denominator seems undisputed for now, and for all countries!

  12. Ricardo

    Professor Richard Clarida wrote:
    With the benefit of hindsight … it seems clear– at least to this author– that the financial crisis and the credit and securitization bubble that preceded it resulted not only from spectacular failures in securities markets– to allocate capital and price default risk– but serious failures also as well by policymakers to adequately understand, regulate, and supervise these markets. Policymakers, academics, and market participants simply didn’t know what they didn’t know. They assumed that either it couldn’t happen (after all, AAA securities ‘never’ default), or if it did, it would be systemically unimportant. Until the tide went out. But by then it was too late.
    This kind of hindsight is only needed by central planners who have taken the reins of power and have driven the wagon over the cliff. Those who believe in real free markets recognized that the tinkers are always going to hose things up. Free traders may make a mistake once in a while but the discipline of the market is severe and quick, but when a central planner makes a mistake it attacks the entire economy and then the central planner only makes it worse by trying to “fix” it.
    I know that I am spitting into the wind but I just can’t help myself. All these people who know what is good for us are going to be the death of us.
    They didn’t know what they didn’t know, which is obvious, but the policymakers still had sufficient hubris to “regulate and supervise markets” into the toilet.
    When will someone who writes like this have the courage to admit that the very structure that gives these ignorant policymaker the power to destroy must be changed? Perhaps we should all join the Tea Party.

  13. 2slugbaits

    So the short version of Clarida’s analysis that if you tell big enough lies and if you’re audacious enough, then naive academics will believe you’re honest if only you’ll wear expensive suits and can show a good academic pedigree from one of the elite business schools. In other words, if only you look like an earnest academic wearing pin stripes instead of tweed.

  14. liberal

    Don wrote, I agree with Jackrabbit, although my own timing was off, I cannot believe any intelligent being could examine price to rent ratios up to 2005 and conclude there was no bubble brewing.
    I’ve been reading Dean Baker since before the dot com bubble burst. Baker correctly called the dot com bubble, based on fundamentals, and correctly called the housing bubble extremely early, based on arguments like the one you’re making.

  15. Benign

    Lame in the extreme. Lots of people saw it coming. Read Barry Ritholtz or Bob Precter. And since when is a stated income no money down loan AAA? This is bullshite, professional self-exoneration that just doesn’t wash.

  16. dd

    Lifeguards were barred from elite financial sector private beaches. Naked swimming was the norm. The risk of drowning was deemed nonexistent. Luckily when it did happen the bodies washed up on the public beaches. The elite financial sector derided the public beach lifeguards as ineffective and demanded their funding be cut.
    Talk about a win-win.

  17. Steven Kopits

    No sympathy from me.
    The housing bubble was readily visible. We discussed the C/S Index around the kitchen table in 2006. A situation in which a top 3% income is required to purchase the median house cannot endure. Either incomes must grow quickly and broadly; or 47% of the housing stock will lie vacant; or housing prices will decline. It’s that simple, and the only plausible long-term outcome is a decline in prices.
    Mike Burry, Meredith Whitney both saw it coming. Why didn’t economists see it coming? Well, I’m sure some did. I’d bet you had some junior guys at the Fed just screaming about household debt levels.
    But there’s also a material failure of education. Can economists read 10-K’s and Q’s? Do they know basic accounting? Are they taught and practiced in matters of ethics and character? (Who resigned from the Fed in protest of its policies? Did they have an obligation to do so?) Are economics students encouraged to pick up the phone and talk to people? (You’d be surprised who’s willing to talk to you!) Can they write and present papers that influence behavior rather than producing stuff that no one reads or cares about? None of these things requires advanced math skills. In fact, the profession’s vaunted math skills didn’t seem to help much at all; and indeed, the basic issues were as visible as picking up The New York Times to read an article or two and doing some back-of-the-envelope math.
    So, I certainly bow to the awesome math skills of guys like Greg Mankiew. But a focus on such skills creates adverse selection (dweeb factor) and fundamentally drives the profession towards intensive, rather than extensive, development. It is built on the assumption that deeper analytics would solve the problem. But the problem wasn’t deep! It was a foremost a crisis of mindset, character and lack of common sense.
    I personally do think it’s time for the profession to take a big re-think. Should you teach economics or teach people how to be economists? These are two different things.

  18. Ricardo

    To follow up on my earlier comment let me offer this quote from a very recent article by Professor Reuven Brenner, of McGill University and David Goldman that can be found here http://www.faqs.org/periodicals/201010/2145026161.html
    No economic recovery will ever occur until governments bury, once and for all, the Keynesian concept of aggregate-demand management and instead take measures to revive incentives to rebuild risk-capital financing by mobilizing the country’s entrepreneurial talent.
    The policy debate is a blame game, but one played by blind men with an elephant. Some say that if the Federal Reserve had not kept interest rates so low for so long, there would have been less credit expansion and fewer defaults. Others say that if the Fed had paid more attention to the external value of the dollar than to price indices or GDP, it would have suppressed the developing bubble in home prices. Still others argue that without official support for subprime securitization, the vast subsidies provided by government-sponsored mortgage funders, and the monopoly position of the heavily conflicted rating agencies, the securitized debt bubble might have been contained. Yet others argue that the proprietary trading focus of deposit-taking institutions made the payments system vulnerable to panic.
    All these observations are true, and all of them are misleading, for the crisis arose not from any of these errors as such but rather from the Keynesian mindset of policy makers and regulators that prevented them from identifying these problems before they combined to threaten the financial system and the long-term health of the economy.

  19. ppcm

    This failure is not the failure of all academics. It is the triumph of politics and politicians over the academics,the pervasion of institutions,the corruption of morale.
    There is no economist in the world having enough granted power as a mean to benevolently damage the world economic balances,without prior instruction.
    The consent was unanimous and no one is making a living by standing against enforced commonly accepted ideologies (not theories,not logic)

  20. 2slugbaits

    Ricardo “…the crisis arose not from any of these errors as such but rather from the Keynesian mindset of policy makers and regulators that prevented them from identifying these problems before they combined to threaten the financial system and the long-term health of the economy.”
    What are you talking about? The problem was due to a lack of regulation, not overeager left-wing policymakers with a “Keynesian mindset” (whatever that means). If academics are guilty of anything it is being naive and underestimating the extent to which their former grad students weren’t really all that interested in proving the efficient market hypothesis, but were rather more interested in just plain old-fashioned greed. I don’t think academics fully appreciated just how corrupt their former students really were. The whiz kids from the biz schools weren’t all that interested in competitive and efficient markets; they were more interested in leveraging, obfuscation, cornering markets and finding the last sucker. I don’t think academics fully appreciated the extent to which some otherwise perfectly respectable folks from fine families were willing to act just like common thieves if given half a chance; and that naivete prevented academics from ever imagining that maybe…just maybe, the market wasn’t sending valid price signals.

  21. djt

    There are professional economists, and financial product sales people that pose as economists. We elide the difference between the two. I’m going to go out on a limb and suggest professional economists (by which I mean those publishing original research in peer-reviewed journals) were largely correct about the portions of the economy in which they worked.
    I don’t think I’m going out on a limb when I saw economists working for publications, news organizations, big banks, and possibly even the fed were not really economists but could be more accurately described as shills for financial products. They may have econmics degrees, but when they are shilling for financial products they are not acting as economists.
    Perhaps the easier approach is to stop labeling people who aren’t economists as economists.

  22. rayllove

    Just to keep the record fair and accurate, here is what Dean Baker wrote on his blog:
    “The crash of the housing bubble will not be pretty. Millions of people stand to lose their homes and life savings. However, it was inevitable. The bubble created a fantasy world that could not continue. At the peak of the bubble, 160,000 people a week were buying a home, most at bubble inflated prices. The longer the bubble persists, the larger the group of people who paid way too much for their home. While it is not good that so many dreams had to be ruined, the number will be even larger if the bubble deflates slowly. So I make no apologies about hoping for the hasty demise of the bubble.” Dean Baker, “Slow Motion Train Wreck” The American Prospect, Aug 2, 2006
    But more than 3 months before that, Micheal Hudson wrote an extensive article which ‘HARPER’S’ published as their cover story. Anyone who has not read it should:
    http://www.insurgentamerican.net/download/MichaelHudson/Hudson_RoadToSerfdom.pdf
    Anyway, Dean Baker has promoted the notion, endlessly, that it was him who did so much to save us from ourselves. But, in truth, it is disingenuous to take credit for something that someone else had forecasted in much greater detail, much earlier, and in a high profile magazine as opposed to an obscure blog.

  23. DavidS

    @2slugbaits, have you seen “Inside Job” yet?
    Your description of “financial salespeople” is probably very accurate, except sadly it also applies to many of the most highly regarded academic economists who are either directly (as consultants) or indirectly (via grants and donations) on Wall Street payrolls.

  24. Nemesis

    Gentlemen, it’s really rather simple. Note in the first chart what the cumulative differential rate of change of growth of private debt to GDP was from the early ’80s to ’07-’08. For those not inclined to break out the calculator or spreadsheet, the cumulative differential rose to an exponential order of magnitude at which point a faster-than-exponential rate of private debt growth had to occur to sustain debt service of the existing debt and GDP growth.
    Of course, if we understood simple exponential mathematics, we would have anticipated long before the “jubilee” threshold was reached that debt growth had a limit bound at which a debt-deflationary “anti-bubble” regime switch would occur with the predictable consequences.
    And one of those consequences is a charge-off of bank loans of 30-40% from the ’07-’08 peak to the point at which the monetary base and bank loans reach parity; bank loans/GDP reach 25-30%; and private debt “catches down” to the trend rate of growth of wages/salaries and production.
    And, no, the US gov’t cannot grow its debt/GDP eventually at a faster-than-exponential rate either. Specifically, were the trend rates of private and total nominal GDP and US gov’t spending, including transfers, to continue at the post-’00 and -’07 rates, the US gov’t will reach its jubiliee threshold of public debt limit bound no later than ’16-’17, the likely point at which net interest will reach and surpass 25% of federal receipts.
    But I’m sorry to say, the situation is worse than this. Peak Oil, peak oil exports, and falling US and global oil imports and consumption per capita will further drag on US and eventually global GDP growth, as US domestic oil production/consumption will continue to decline at a minimum rate of 3.2% per capita, which will not allow a continuing growth of private debt to consume growing oil imports and cheap goods from China-Asia to give the appearance that the US economy is “growing”, when what was actually growing were oil and cheap goods imports, debt/income, and debt/GDP.
    Now we have to pay down debt, default upon debt, restructure debt, and pay down or default on debt, or some combination of these choices at a rate of at least 3-4%/yr. for the next decade. We will not be able to count on Keynesian gov’t “stimulus”, apart from most of the net incremental borrowing and spending by the US gov’t going to bail out the rentier-parasite banksters and provide subsistence income support to the elderly, poor, and unemployed/underemployed.
    In effect, the secular debt-deflationary “anti-bubble” regime will last throughout the decade, be exacerbated by Peak Oil and Boomer demographic drag effects, and eventually lead to US gov’t default.

  25. Bryce

    2slugbaits: “The problem was due to a lack of regulation”
    The sine qua non of the crisis was the easy money supplied by the gov’t bureacrats at central banks. While the loosening of the leverage ratios on investment banks [in response to European competition] was ill-advise regulatory loosening, to say there was a lack of regulation generally is inaccurate.
    Banks have been heavily regulated for a long time. Have you seen the thick book you get when you buy a corp. bond? You can say “stupidly regulated” & I would buy it. That is what gov’t can be expected to do.
    A flagrant & pertinant example of stupid regulation concerns regulation of the rating agencies. The gov’t essentially set up an oligopoly & required that the seller of bonds pay the fee! Rather than the buyer of the bonds. Backwards from what a free market would have produced.

  26. Michael K

    What’s interesting here is how we as humans fail to discern paradigm shifts from bubbles that blow up and pop. The two charts of shadow bank liabilities and total bank liabilities could be interpreted rather as a paradigm shift versus merely a bubble to pop. Some degree of the shadow banking ‘bubble’ is a function of financial technology increases, much of which is likely here to stay.
    To much the same line of thought – make a chart of productivity growth and you’ll likely see an above trend ‘bubble’ aberration in recent years, something that logging the data might still not undo.
    But that productivity growth is a function of better technology (more efficient production functions here to stay), partly what an overoptimistic stock market (at the time) foreshadowed would yield long run dividends in company performance in the late 90s. That was a paradigm shift.
    Back to shadow banking. Same type of paradigm shift, just in financial technology.
    Now any economist would say a blow up in that sector was not likely because the ‘bubble’ had blown up for so long, and thus was the result of a shift in paradigms: technology increases in finance.
    Now anyone with an ounce of common sense and awareness of what was happening from 2003+ on the ground in the mortgage sector (0 down loans to people who might eventually not have jobs) knew we were merely past the level of paradigm shift, and well into bubble. And anyone with that common sense plus knowledge of what banks and insurance companies actually had off and on their balance sheets (a much smaller group, Goldman included) knew the impact would be catastrophic.
    Most economists missing the big picture may be merely a function of their 1) lack of involvement and connection with real people on the ground in the last stage of the bubble and 2) lack of knowledge about the true state of the banking sector. It’s hard to know everything. There’s a lot to study and learn out there, especially nowadays. But I think the Ivory Tower syndrome lends a partial explanation to what happened.
    All of the most brilliant math/models in the world fails to do much than wow, if indeed there is an information disconnect between its practictioners (economists) and the world as a whole. What we have here is partially a tale of imperfect information helping exacerbate a market failure.
    The jury is still out whether shadow banking’s existence equates entirely with a bubble in credit, or a paradigm change which sets a new higher level of steady state total credit out there (as a function of normal base credit). My gut says paradigm change, because it is a function of better technology, a better production function in banking. Granted, maybe we got carried away in its use, but most of 30 years of financial innovation doesn’t disappear just because the last 7 was a mess.
    On the topic of paradigm shifts vs. bubbles, how can it be sustainable that the Japanese with a government sector 25% the size of its GDP continue to finance half of its operations with new debt (so 10%+ of GDP), be dependent on an average 1% (half or third of the rest of the developed world) cost of money, and have the flattest/lowest level yield curve as well as strongest currency in the developed world ? Add to that dependency entirely on internal financing, much of whom are demographically going to turn into spenders vs. savers during the coming years.
    I am bewildered to say the least. Is a low growth outlook and a country full of people who are actually willing to collude to increase the collective benefit vs getting a better return as individuals (ie investing retirement in foreign bonds and equity) enough to make it a paradigm shift?
    Of course I’m leaving out the balancing impact of Japan’s ~$1T in external reserves, but it makes fr interesting discussion nonetheless.

  27. Ivars

    I suggest explanation by D. Sorniette. It was a succession of bubbles since 1980 -ies that finally failed to find the new Mega bubble so that indebtedness can continue to grow. And he predicted the collapse rather accurately:
    http://videolectures.net/ccss09_sornette_fbreb/
    Or just latest presentation:
    http://www.er.ethz.ch/presentations/2007Crisis_robust_illusion_Majorca21Sept10.pdf
    I guess these non-linear things and thinking are totally strange to economists education who only use linear regression and Gaussian distribution to make themselves happy and fool others. The problem with economists seem to be, they do not understand how economy and other social systems work, what are the right models, and they of course stick to old models which they have been repeating all their lives contrary to evidence of numerous bubbles and crashes, euphorias and pain.
    The banks made the bubble, period. Deregulation from stringent but correct After the Great depression bank regulation was bought by banks from government, slowly but surely until they got rid of the last obstacle in 1999.

  28. Nemesis

    Michael K,
    The productivity gains so often touted by e-CON-omists to rationalize the massive debt-money inflation and resulting bubble since the ’80s was actually a function of billions of dollars of US supranational firms’ investment abroad to produce cheap goods (cheap consumer goods and inputs for domestic firms), as well as importing now two-thirds of our oil production (with the US having just 2% of the world’s oil reserves while consuming 20% of global oil production).
    Approximately 40-45% of US “exports” are actually capital goods (and other) shipped to US subsidiaries and contract producers abroad, particularly since the ’90s in China-Asia.
    Since US domestic oil production achieved a secondary peak in ’85 (falling at a 3.2%/yr. rate per capita since), we replaced domestic value-add goods production with cheap imports, cheapening debt-money (since the early ’80s in nominal interest rate terms), increasing returns to financial capital’s share of GDP, and increasing debt/income and debt/GDP, which we called “growth”.
    Moreover, the discoveries and inventions from the ’50s-’60s in microelectronics, microcomputers, and networking and wireless communications reached the so-called S-curve take-off stage in the ’80s (MSFT, AAPL, etc.) and peaked with the growth boom in the mid- to late ’90s, at which point the maturation phase of the S-curve commenced to date (firms’ revenues and earnings decelerating to converge with trend GDP growth over time). IT and internetworking combined with “financial innovation” in a self-reinforcing effect to encourage the secular reflationary debt-money cycle and terminal phase of the bubble to a share of GDP unsurpassed in US history.
    What we as a country and economy are left with is a largely deindustrialized, decapitalized, militarized, and financialized economy; massive debt overhang and debt service of ~25% of private GDP; EXTREME wealth and income concentration (top 1-10% of US households hold 85% of financial wealth and receive nearly half of all income); total gov’t spending plus total debt service equivalent to 80% of private GDP; imperial military spending at 9-10% of private GDP; US gov’t debt held by the public at 100%+ of private GDP; net fossil fuel imports at 5% of private GDP; and 80-90% of the US population facing effectively no net capital wealth, and the eldest of the population segment spending end of life utterly dependent upon gov’t transfers or family and the kindness of strangers.
    And now we are faced with global peak oil production (and eventually peak exports from oil-producing nations and peak imports for oil-importing nations) with the three major geoeconomic trading blocs having achieved par (thanks to US supranational firms’ investment and technology transfer) with GDP and oil imports and consumption.
    We now face a zero-sum oil situation in the world, meaning that China-Asia cannot continue to grow GDP and oil imports and consumption without the US and/or EU reducing consumption and imports, and thereby reducing real GDP per capita, which in turn means less domestic investment, profits, payrolls, and further capital accumulation (and thus less capitalism).
    And oil above $80 is well into historic recession territory for the US, EU, and Japanese economies.
    The new paradigm you mention is best perceived as one of “no growth” and ongoing contraction in real GDP per capita terms, and eventual US fiscal insolvency and imperial military withdrawal from the 1,000 US military bases and related facilities abroad.

  29. MarkS

    Michael K – your paradigm shift you suggest has been created by computerized telecommunications and risk obfuscation (courtesy of financial derivatives), and now free indemnification (via treasury and central bank subsidies). It remains to be seen how much of the shadow banking system will survive the deleveraging and liquidity deflation that is sure to occur in the next ten years.
    Government (professional policy makers) know that the payment system is confounded by the risks assumed by the proprietary trading of the money center banks. I would suggest that logically, government would be best off segregating commercial from investment banking. That would reimpose the historical risk structure to securitization. I would also suggest that if government doesn’t resegregate commercial and investment banking, that sovereign default is inevitable.

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